Sovereign Risk, Bank Funding and Investors’ Pessimism

Ester Faia

No 11340, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Data show that sovereign risk reduces liquidity, increases funding cost and risk of banks highly exposed to it. A feedback loop exists between sovereign and bank risk. I build a model that rationalizes those links. Banks act as delegated monitors and invest in risky projects and in risky sovereign bonds. As investors hear rumors of increased sovereign risk, they run the bank (via global games). Banks could rollover liquidity in repo market using government bonds as collateral, but as sovereign risk raises collateral values shrink. Overall banks’ liquidity falls (its cost increases) and so does banks’ credit. In this context noisy news (announcements with signal extraction) of consolidation policy are recessionary in the short run, as they contribute to investors and banks pessimism, and mildly expansionary in the medium run. The banks liquidity channel plays a major role in the fiscal transmission.

Keywords: Liquidity risk; Sovereign risk; Feedback loops; Banks’ funding costs; Repo freezes (search for similar items in EconPapers)
JEL-codes: E5 E6 G3 (search for similar items in EconPapers)
Date: 2016-06
New Economics Papers: this item is included in nep-ban, nep-dge, nep-mac and nep-net
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